Editor’s note: This article was first published in June 2011, and its observation that ETFs were investors’ favourite product in 2010, thanks to emerging-market bonds and commodities, reflects 2010-2011.
We’re answering a reader who asked us: what is the difference between CDS and ETFs? When we started explaining the types of investment products and vehicles available on the market, I didn’t stop to cover CDS, partly because this product is very hard for small investors to access. Even so, we’ll explain it simply so that anyone can understand it.
ETFs defined: We already covered this product in a previous article, What an ETF is. In brief, this derivative, whose name stands for exchange-traded fund, works like a traditional investment fund, except that an ETF is listed on the stock market just like shares, so, as with a share, you can sell it whenever you see fit.
In 2010 the ETF was investors’ favourite product because, even though many of them didn’t know it, their baskets included bonds and commodities from emerging countries, which turned out to be very profitable. In short, they are listed funds whose holdings trade on the stock exchange.
CDS defined: Let’s start by saying, whatever some people may think, that this product was one of those responsible for the crisis, and let’s see why.
CDS, or credit default swaps, are basically an insurance contract in which an institution, government or bank sells its portfolio of debtors to a third party (an investor, speculator or insurance company), which earns a return for taking on the risk.
Why are they responsible for the crisis?
Simply because the banks granted those mortgages fearlessly and without guarantees, and turned them into CDS. They weren’t afraid of customers defaulting, because they had passed the risk on to who knows whom. The banks even put those same CDS into their own investment funds through the ETFs mentioned above. Debt became a product traded on the stock market, when we all know that debt is debt. Whoever created this product was a great magician.
It’s ironic that thousands of investors around the world who put their money into investment funds or ETFs were, in fact, investing in their own mortgages.
Here is an example of what happened.
Banco Santander grants 100,000 mortgages, creating mortgage debt. To avoid taking any risk, it turns those mortgages into CDS and sells them to a large investor, who puts them into an exchange-traded fund (ETF). Months later, Banco Santander launches its own range of investment funds and puts into them the ETFs whose baskets hold the CDS of the mortgages it granted.
Not even the best financier in the world could explain how this is possible. We’ve used Banco Santander as an example because every bank did this, so they all bought each other’s junk, and Mr Emilio Botín (Santander’s chairman) is no exception among the creators of toxic assets.
Further reading
Featured image: David Shankbone, CC BY-SA 3.0, via Wikimedia Commons.
